The spread is usually described as a ratio of the highest paid partner’s income to the lowest paid partner’s income.  So a firm where the highest paid partner earns $1,000,000 and the lowest paid partner earns $100,000 has a spread of 10:1.  We are often asked about whether a particular firm’s compensation spread is appropriate.  There are two answers to that. 

The first is what most firms are initially asking — are we in line with what other similarly situated firms are doing?  Now the simple solution is to turn to survey data, determine the comparables and compare.  But let’s explore this a bit further.  Are we asking about all partners or just equity partners?  Firms with two tier ownership might be interested in a different number then a single tier structured firm.  Do we exclude the part-time or semi-retired partner?  Do we exclude the outlier partner at the top of the pay list who is an anomaly?  The ratio is going to vary, possibly quite a bit, based on how we address each of these questions.

What we have found in our research is that the acceptance of a greater spread (higher ratio) increases with size.  Also the differences between single tier and multiple tier spreads becomes noticeable in firms with more than 10 lawyers and significant for firms with more than 75 lawyers.  While smaller law firms (20 or fewer lawyers) are generally comfortable with all partner ratios under 3.0; large law firms (over 150 lawyers) are more likely to have all partner ratios of 4.0 to 9.9 to 1.0.  The diversity of views on this is remarkable.  6% of these large law firms have ratios in the 2.0 to 2.9 range while another 6% have ratios in excess of 20 to 1.

The second answer is related to the culture of the firm.  Here the answer depends on the individual firm’s ownership environment.  Some law firms manage the spread and some do not.  When they do manage it, the reason is often a cultural attribute.  It is their collective sense of propriety for the relationship among the owners.  A partner once asked me if I make 10 times one of my partners, is that partner really a partner of mine?  Interesting question that articulates the relationship that exists between pay and culture.  When the ratio is managed it is in a structured compensation/ownership system of points or tiers or similar arrangement.  Other firms take a decidedly different view — one that says this is an unimportant and/or irrelevant factor.  This is more likely in confederation style law firms or law firms that prize individual enterprise as the key differentiating factor.  Note that while one might expect that firms with formulaic compensation systems would have higher ratios, this has not been borne out in our research.  Certainly there might be a greater tendency for this result in a system that is unmanaged by subjective factors, but it appears that the lawyers drawn to law firms with such systems tend to join and stay together because there is not a significant performance difference among them.

Merger discussions generally center around the rationale for and methods of putting two law firms together.  The focus is on the opportunities to access new clients and markets, to qualify for more interesting engagements, and to bring on additional expertise.  There is a long list of issues to consider — strategy, culture, conflicts, financial results and the like.  Then there are structure concerns, redundancies, tax considerations, and more to negotiate prior to bringing the transaction to a successful conclusion.  Yet even with careful planning, every once in a while the pre-merger thinking misses the mark and the post-merger firm is not destined to make it. 
 
Like pre-nuptial agreements, de-merger clauses are often not considered appropriate.  Who wants to plan the breakup at the beginning of the relationship?  And certainly an “out” option may delay and complicate integration of the two firms — such as sharing clients, integrating service teams and combining administrative functions.  A de-merger clause may not be appropriate in all situations, but it can be helpful.  Undoing a failed merger is tricky under the best situations, it becomes much more challenging when one firm has given up its identity as part of the deal.  Having a roadmap can ease the difficult and sometimes contentious task of undoing the deal.
 
Here are some factors where a de-merger clause might be helpful:
 
Protecting client relationships — this can be complicated in two ways:  1) how client relationship responsibility is assigned in the combined firm (expertise, location, succession plan and the like), and; 2) who clients want to continue with as their advisors (the client’s wishes control).  A de-merger clause should think through how to fairly treat the firm who brought the client to the dance.  Then there are the new post merger clients.  Here the complications are how the client came to the new firm and where it ends up after the break up.  Particularly difficult are jointly obtained clients where only one firm will serve the client going forward.
 
People — A law firm’s most precious resources are its people.  Generally one would expect to have people return to their pre-merger firm.  Many times it is not quite so simple.  There may be some unofficial recruiting going on behind the scenes.  Some individuals may prefer to “cross-over” to the other firm.  Then there are the displaced personnel lost during rationalization.  Finally there are the reluctant participants — partners who went along with the deal with reservations and now desperately want to take their practices and leave.  Each of these scenarios can be anticipated and protocols agreed to as part of a de-merger clause. 
 
Infrastructure — It is more an issue when the firms have combined physically.  Someone will need to move or there will be costs to segregate and reconfigure space to accommodate two separate firms.  The same holds for technology, library and other shared administrative services.
 
Partial acquisitions — These are deals where not all partners become equity partners in the new firm.  In these instances the de-equitized partners are often bought out of their equity positions as part of the transaction.  If these buy-outs are relatively minor as a cost of the deal, a de-merger clause might be helpful.
 
When are de-merger clauses possibly not helpful?
 
Succession deals — The purpose of a succession deal is to provide an exit strategy for “sellers” while transferring clients and market presence to the “buyers.”  The acquirer will invest heavily in making the transfer successful and it would not be terribly helpful for the seller to have an out to pursue a more attractive offer that could come along.
 
Integration efforts — Forging a single firm out of the two predecessor firms is challenging and requires three to five years under good conditions.  Having a short term strategy to undo the deal complicates these efforts.  It is just common sense that each party will tend to protect their positions while the option exists.  Thus a discord to the efforts required to go forward as a single firm. 

A recent Wall Street Journal article (9/24/07) “A Stingier Job Market Awaits New Attorneys“* discussed some of the less reported aspects of beginning a career in law — that most new lawyers do not get the top salaries currently being written about ($160,000), many finding employment elusive and law school debt burdens that run $50,000 to $80,000 or more.  Add to that consumer debt and you have a significant fiscal challenge very early on in life.

I read the WSJ article just after reading an excellent article entitled “Personal Financial Ratios:  An Elegant Road Map to Financial Health and Retirement“ in the Journal of Financial Planning authored by Charles J. Farrell.  The Farrell article uses simple ratios to demonstrate how lifestyle (living expenses, debt repayment and savings rates) can be monitored to achieve retirement goals.  He explains the underlying assumptions, provides a realistic budget, and exhorts fiscal discipline.  Be warned, this frank depiction of what it takes to reach retirement debt free and with sufficient savings may shock those who listen to the traditional wisdom of how much debt someone can afford and still accumulate wealth.

Bringing these two articles together suggests that many law students should plan more conservative lifestyles.   Expensive cars and vacations, frequent entertainment (dining out, theater, etc) may need to be deferred until income, savings and debt are brought in line.  Unspoken in Farrell’s article, but certainly a possibility is that social security and Medicare will not provide for recent graduates when they reach retirement in the same manner that those programs do for current retirees.  If those social programs were to materially change for the worse; the more aggressive scenario presented in the article would become much more important a consideration.

* a WSJ online subscription may be needed for this link to work.

Let’s begin with a slightly different perspective on the currently hot area of succession.  When we talk about the need for succession and transition within a law firm, we tend to focus on individuals age 60 and over and their role.  Today let’s focus on one position where a younger partner is more and more likely to find him or her self — Managing Partner. 

Managing partner used to be the final act.  Retirement afterwards was common.  But today we see more and more fifty something managing partners who are ready to step down from that post, having held it for five to ten years.  Still in their 50s, most do not seek to leave their firm or the practice of law.  Yet for many, particularly those who have left the practice for ten years to serve the firm’s interests, the return presents some challenges and questions.  One of those questions is:  “What happens to my compensation?”

The common refrain on this (if there really is one) is one year for every two years as managing partner with up to three years protection of current compensation.  We prefer a slightly more nuanced approach to this:  One year of no downward adjustment from the average of the last three year’s compensation position for each two years as managing partner up to a maximum of three years protection.  Position is different from compensation.  Position considers where the managing partner has been compensated relative to average, top, median and entry level partners.  The protection seeks to maintain the “sustained position” (hence the average of prior three years) as a floor for compensation of the managing partner during the post-managing partner protection period.  It does allow for the compensation to go down if the overall profitability of the firm declines, which we hope many would find a reasonable position.

But when a specific program is being developed, the common refrain or even my twist on it becomes a bit tricky unless the firm just wants to provide an unencumbered entitlement to the departing managing partner (which may be fine as well, if it is deliberate).  We believe there is a more fundamental question:  ”What do you do with a managing partner, when he stops being a managing partner?”.  The answer to that guides you on the answer to the program specifics.  And the answer to our question is driven by a number of variables: firm size, incumbent age, firm governance charter, practice area, clientele and the like.  What might make sense for the 70 year old managing partner of a ten partner firm who is retiring at the end of term may make no sense for the fifty year old managing partner who after ten years as managing partner of a two hundred partner firm is very much interested in returning to the practice of law.

• So it is helpful to engage in a dialogue about the following. The exact wording and scope will vary depending on the answers (some of which may already be well known by all parties).
• Is this for someone about to step down or is a new candidate requesting this before signing on for the job?
• How old is this person?
• How long has the managing partner been in the position?
• Was the position full-time (turn over of client relationships and cease practicing law)?  If not, how much did the managing partner position intrude on practicing law, business generation and market presence?
• What kind of practice and client following did this person have?  How permanent was the relationship transfer?
• How visible was the position in the market (i.e. did it have a high-profile public CEO face or was it more of an internal COO orientation)?
• What is the role of an ex-managing partner upon leaving the post (is there any transition, formal or otherwise expected of this person)?
• What kind of compensation program is used for the general population of partners?
• What compensation program is used for the managing partner position?
• What does this person want to do – We know the managing partner often says that he/she wants to return to the practice of law, but there are varying degrees of that statement and it helps to understand what each aide is thinking.

The best program is one that works to meet the managing partner and firm’s interests and considers the challenges and timeframes to transition from the formal leadership role of managing partner into the next role — whatever that may be.

Welcome!  This is a new communication venture for Altman Weil and for me.  We plan to cover the area of partner compensation most heavily.  Other partner issues and other compensation issues will also be covered based on the questions and issues our clients are raising.  We hope you find it thought provoking and useful.